Composition of the UBS DERI risk indicator

The UBS DERI (UBS Dynamic Equity Risk Indicator) was developed by UBS IB Investment Research, a unit that is independent from other UBS business areas, and measures the sentiment on the global financial markets on a daily basis. To this end, the UBS DERI uses selected benchmarks that it condenses into one number, based on certain statistical methods. Therewith, the indicator offers a simplified and concentrated indication of the sentiment in the global equity market.

In detail, the UBS DERI takes the following factors into account:

Price fluctuations of equity options

As a measure for implied volatility, the VIX®, which is based on CBOE options on the S&P 500 Index®, and the VDAX®, which is based on EUREX options on the DAX®, are used. As implied volatilities can significantly influence option prices, both the VIX® as well as the VDAX® can be regarded as an indicator of the costs (in percentages) that are required for one year to hedge a portfolio (consisting of US or German standard equities) against the systematic risk. In principle, the following applies: the higher the VIX® or VDAX®, the higher the perceived systematic risk tends to be, the lower the risk appetite and the more negative the market sentiment (inverse relationship).

Risk premiums of corporate bonds

As a rule, corporate bonds have a greater risk of loss than US government bonds. For this reason, the yields on corporate bonds demanded by investors are usually higher than the yields on US government bonds. Therefore, the UBS DERI indicator takes into account the yield premium (risk premium) that bonds of American companies with a Moody‘s rating of ‘BAA’ (the lowest investment grade rating) have on average compared to 10-year US government bonds. In principle, the following applies: the higher the risk premium of corporate bonds, the higher the perceived issuer risk, the lower the risk appetite and the more negative the market sentiment (inverse relationship).

Swap spreads

Banks lend each other money on the interbank market by means of swap transactions. Here they agree on the interest rate of the swap that will be used until maturity of the swap transaction. The swap spread corresponds to the difference between the agreed interest rate of the swap and the yields on government bonds with the same maturity. In principle, the following tends to apply: the higher the swap spread, the higher the expected counterparty risk, the lower the risk appetite and the more negative the market sentiment (inverse relationship).

Currency fluctuations

The UBS DERI indicator takes into account volatilities that have been realized in the past with currency options. The relationships of the following currencies to the US dollar are included: the euro (until 1999, the Deutsche mark), Japanese yen, Swiss franc, British pound and Australian dollar. In principle, the following applies: the higher the expected volatilities in the currency options, the higher the perceived systematic risk tends to be, the lower the risk appetite and the more negative the market sentiment (inverse relationship).

Relative development between cyclical and defensive stocks

If the majority of investors have a positive outlook on the economy, they prefer to invest in cyclical rather than defensive equities as this approach promises higher returns. For this reason, the UBS DERI indicator measures the difference in performance between cyclical and defensive stocks. Equities from the consumer durable goods industry, heavy industry, the raw materials sector and the technology industry are regarded as cyclical stocks. In contrast, defensive stocks include the consumer non-durable goods industry, the health sector, the telecommunications industry as well as the utilities sector. In principle, the following applies: the better the relative development of cyclical compared to defensive stocks, the lower the perceived systematic risk, the higher the risk appetite and the more positive the market sentiment (direct relationship).

During positive market phases, more and more money flows into higher risk investment regions, such as equities from emerging countries, as market participants hope to generate higher yields here. This pro-cyclical approach tends to strengthen the fluctuation bandwidth of equity prices in these investment regions and usually ensures a high ‘beta.’ In this case, the beta shows how strongly a country index fluctuates compared to the global equity market. The UBS DERI indicator thus measures the excess yield between high-beta equity regions and a global equity portfolio. In principle, the following applies: the higher this excess yield, the lower the perceived systematic risk, the higher the risk appetite and the more positive the market sentiment (direct relationship).

The principles that apply to countries also apply to sectors. The UBS DERI indicator thus also measures the excess yield between high-beta equity sectors and a global equity portfolio. In principle, the following applies: the higher this excess yield, the lower the perceived systematic risk, the higher the risk appetite and the more positive the market sentiment (direct relationship).

Equity market momentum

The momentum of the equity market is measured using the MSCI AC World Index compared to its 200-day moving average. Equities in the traditional sense of finance are regarded as a risky asset class. A value of more than ‘1’ indicates that the index is above average, while a value of less than ‘1’ indicates that the index is below average. In principle, the following applies: the higher the index is above its average (i.e. the more the equities recently increased), the lower the perceived systematic risk, the higher the risk appetite and the more positive the market sentiment (direct relationship).